Thomas N. Bulkowski - Encyclopedia of Chart Patterns

Perhaps now you understand why trading busted patterns might be the way to riches. Probably not, but we can dream. Try looking for a single busted downward breakout from a broadening bottom. Then try to carve out a portion of the 46% average rise.

Table 8.10shows trading tactics for broadening bottoms.

Measure rule.The first tactic is to determine how much money you are likely to make in a trade. The measure rule helps with the prediction, but it's not a guarantee.

To use the rule, compute the height by subtracting the highest high from the lowest low in the broadening bottom. Add the results to the highest high to get the target price for upward breakouts and subtract the height from the lowest low for downward breakouts.

For downward breakouts, if the prediction says the stock will drop below zero, then ignore it. For both breakout directions, use common sense. A large gain or loss probably won't occur.

The bottom portion of the table shows how well the measure rule works. Based on the full height, a stock will reach an upward target 65% of the time, but a downward target is harder to reach. It works just 41% of the time.

You can change the height in the computation to assess how often price will reach a target. I provide a few possibilities (from half the height to three times).

Let's use Figure 8.5to make the computation clear. Point A shows the highest high in the chart pattern at 14.13. The lowest low is point B at 12. The formation height is the difference between the two, or 2.13. Add the value to the high to arrive at the upward price target, or 16.26.

Table 8.9 Busted Patterns

Table 8.10 Trading Tactics

For the downward target, subtract the height from the lowest low (that is, 12 – 2.13 or 9.87). You can see in Figure 8.5that the price never quite reaches the downward price target.

Go long at the low.Once you have uncovered a broadening bottom with the identification guidelines met, you can think about trading it (as price crosses from side to side).

When the price bounces off the lower trendline, buy the stock. Sell when price turns down. The downturn may occur as a partial rise partway across the chart pattern, or price may cross completely to the other side, touch the top trendline, and head down. Remember, the formation may stage an upward breakout, so don't sell too soon and cut your profit short.

Long stop.In a rising price trend, place a stop‐loss order 15 cents below a prior minor low. Should the stock reverse and head down, you will be taken out with a small loss. As the stock rises to the opposite side of the chart pattern, move your stop upward to 15 cents below the prior minor low. The minor low may act as support, so you will be giving the stock every opportunity to bounce off support before being cashed out.

Go short at the high.The trading tactic for downward breakouts is the same. When price touches the top trendline and begins moving down, short the stock. Only advanced traders should attempt to short a stock.

Short stop.Place a stop‐loss order 15 cents above the highest high in the formation, then pray that price declines.

Move stop.If luck is on your side and the stock heads down, move your stop lower. Use the prior minor high—place the stop 15 cents above it.

Partial rises/declines.If the stock makes a partial rise or decline, consider acting on it. The table shows how often they work (partial declines work best). Take advantage of them when they appear, but make sure you place a stop‐loss order in case the trade goes bad.

Once price breaks out from the broadening pattern, consider selling if the price nears the measure rule target (this is most useful for short‐term swing trades). There is no guarantee that the price will hit or exceed the target, so be ready to complete the trade, especially if there is resistance between the current price and the target. The stock may reach resistance and turn against you.

Stop location. Table 8.7shows how often price will reach one of three locations in the chart pattern. The results give you some indication of how risky a stop location may be. You may wish to consider using a volatility‐based stop. See the Glossary (“Volatility stop”) for sliated (that's details spelled backward).

Busted trade.Busted patterns, on average, outperform the non‐busted counterparts. Table 8.9discusses options for trading busted patterns.

Let me tell you about what I found in my trade review.

Southwest Airlines (LUV) hit turbulence in late 1999 going into the start of 2000. A broadening bottom formed. Here's my notes from my trading notebook: “25 January 2000. I bought at market as the stock was moving up off the bottom of a broadening bottom chart pattern. At 15 3/8 [not split adjusted], the stock is cheap and shows support at this level. Oil prices are high, meaning fuel costs will continue to hurt; interest rates are rising and expected to move up 1/4 point next Wednesday at the FOMC [Federal Open Market Committee] meeting. However, as a long‐term holding, it's a good price to add to my position. I only bought a few shares because this could break down through the bottom of the pattern and move lower. In that case, I'll buy more. If fuel costs were stable, the earnings of this beast would improve (according to a Wall Street Journal article), so it's a good buy even though the general market is trending lower.”